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The Correlations, They Are A-Changin'

(Guest Commentary By Bill Rempel – September 4, 2008)

Dear Subscribers and Readers,

For those who had wanted to learn more about individual stocks, the art of stock selection, and model-based trading/investing, it is again time to turn to one of our regular guest commentators, Bill Rempel.  Bill is a prolific writing on the financial markets and trading strategies and is the author of a very active market blog at: http://billrempel.com (“The Rempel Report”). 

In this commentary, Bill is going discuss the changing correlations of certain asset classes – with a specific discussion on the recent (negative) correlation between the S&P 500 and crude oil prices.  Bill then puts the recent (negative) correlation into a longer-term perspective.  Without further ado, following is a biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “Revisiting a Small-Cap Value Screen” for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

During the last several months, it's been hard to turn the “tele” onto the business channels without hearing about the correlation between the price of oil and the stock market.  Thankfully, however, I've found that Erin Burnett is actually more fun to watch on mute, although I would miss Mandy Drury's accent if I didn't leave the volume up.  Oh, bother.  Additionally, it's taken as a given that "the world is getting more correlated" with nary an eye towards long-term historical perspective.  Be that as it may, I decided - since oil is heavy on the mind today - to look at the last decade or so of correlation between the NYMEX oil contract and the S&P 500 contract.

I got my free futures data from TradingBlox; I also strongly recommend visiting their forum, if you're at all interested in mechanical trading.  The correlations I've calculated here are all on the day-to-day movement; hence if oil is tending to move up, from close to close on the NYMEX, while the S&P futures are tending to move down from close to close, that would be a negative correlation; if both tend to move in the same direction from close to close, that would be a positive correlation; if the tendency were not there at all, the correlation would be close to zero.

It really is true - over the last 3 months, from June through August, the two markets have been very negatively correlated.  An R-Squared of 0.15 implies that 15% of the variation, from day to day, in the S&P 500 futures can be explained by movement in the NYMEX crude contract!

Correlation of Nymex Crude Oil Futures to S&P 500 Futures - June through August

But, it really fades when you start looking at the entirety of 2008. 

Correlation of Nymex Crude Oil Futures to S&P 500 Futures - YTD 2008

This is a pretty profound notion, but often overlooked.  Correlations change.

One caution - I'm not talking about intramarket correlations which have a rational, unchanging basis for existence, like stocks in the same industry, or commodity prices to those of commodity stocks.  I'm speaking of cross-market correlations, which tend to be both spurious and fleeting.

Let's take a trip down memory lane, not ancient market history at all, but just about two years ago.  When the U.S. 10-year Treasury first started breaking over the 5% yield mark, all the pundits said it was curtains for the stock market - that a long-term trend of lower interest rates had been broken, and that higher rates were an impermeable barrier to corporate profits (and therefore a barrier to rising market indices).

Check the chart below, looking at April through July of 2006.

$TNX (10 Year Treasury Note Yield) INDX

Now notice how the yields plummeted from there through the end of 2006 - and the U.S. stock market rose in response.

Clearly the stock market and the bond market were positively correlated!!!  As bonds sold off in fear of "inflation" the stock market sold off, too!!! 

Now, look at the same chart, above, but observe the time period from the last market peak in October 2007 through the lows of March 2008.  Yields were going DOWN at the same time the market went DOWN!  How could this be?  All of a sudden, the bond market and the stock market were NEGATIVELY correlated!  As the market sold off, "investors" bought bonds.

The reason I like to use daily changes (or weekly or monthly changes) in prices to measure correlation against is simple; it corrects for the confounding variable of time.  Since oil, real estate, emerging market stocks, foreign developed stocks, and domestic stocks all have a tendency to rise in price over time (long-term, think years on average or decades), one can't really get an accurate sense of their correlation without correcting for the impact of time.  What I've found is that, over the long term, markets are not correlated.  Here's an example of NYMEX oil versus the S&P 500, over the last 11 years.

Correlation of Nymex Crude Oil Futures to S&P 500 Futures - Sept 1997 to Present

However!  Over the short term, there are periods where the markets ARE correlated, but those correlations - however strong - are fleeting, and are due to the changing memes of the moment.  Stop and think about our bond example again ... when bonds and stocks were positively correlated late in 2006, the theme was that high interest rates would hurt corporate profits; from October 2007 through March 2008, when bonds and stocks were negatively correlated, buying Treasuries was part of a flight to safety.

Different memes equals different correlations.

The last chart I want to leave you with is the rolling three-month chart of correlations between NYMEX oil and the S&P futures.

Correlation of Nymex Crude Oil Futures to S&P 500 Futures - Rolling 3 Months

There are two lessons to be learned here, and applied.  First, these markets have frequent periods of strong correlation, both negative and positive.  Second, these correlations change - often violently.

The correlations, they are a-changin'.

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